A Hidden Reason Forest Laboratories' Future Looks Bright

Here at The Motley Fool, I've long cautioned investors to keep a close eye on inventory levels. It's a part of my standard diligence when searching for the market's best stocks. I think a quarterly checkup can help you spot potential problems. For many companies, products that sit on the shelves too long can become big trouble. Stale inventory may be sold for lower prices, hurting profitability. In extreme cases, it may be written off completely and sent to the shredder.

Basic guidelinesIn this series, I examine inventory using a simple rule of thumb: Inventory increases ought to roughly parallel revenue increases. If inventory bloats more quickly than sales grow, this might be a sign that expected sales haven't materialized. Is the current inventory situation at Forest Laboratories (NYSE: FRX) out of line? To figure that out, start by comparing the company's inventory growth to sales growth. How is Forest Laboratories doing by this quick checkup? At first glance, pretty well. Trailing-12-month revenue increased 7.9%, and inventory increased 2.5%. Over the sequential quarterly period, the trend looks healthy. Revenue grew 2.7%, and inventory dropped 2.1%.

Advanced inventoryI don't stop my checkup there, because the type of inventory can matter even more than the overall quantity. There's even one type of inventory bulge we sometimes like to see. You can check for it by examining the quarterly filings to evaluate the different kinds of inventory: raw materials, work-in-progress inventory, and finished goods. (Some companies report the first two types as a single category.)

A company ramping up for increased demand may increase raw materials and work-in-progress inventory at a faster rate when it expects robust future growth. As such, we might consider oversized growth in those categories to offer a clue to a brighter future, and a clue that most other investors will miss. We call it "positive inventory divergence."

On the other hand, if we see a big increase in finished goods, that often means product isn't moving as well as expected, and it's time to hunker down with the filings and conference calls to find out why.

What's going on with the inventory at Forest Laboratories? I chart the details below for both quarterly and 12-month periods.

Let's dig into the inventory specifics. On a trailing-12-month basis, raw materials inventory was the fastest-growing segment, up 16.1%. On a sequential-quarter basis, raw materials inventory was also the fastest-growing segment, up 35.8%. Forest Laboratories seems to be handling inventory well enough, but the individual segments don't provide a clear signal. Forest Laboratories may display positive inventory divergence, suggesting that management sees increased demand on the horizon.

Foolish bottom lineWhen you're doing your research, remember that aggregate numbers such as inventory balances often mask situations that are more complex than they appear. Even the detailed numbers don't give us the final word. When in doubt, listen to the conference call, or contact investor relations. What at first looks like a problem may actually signal a stock that will provide the market's best returns. And what might look hunky-dory at first glance could actually be warning you to cut your losses before the rest of the Street wises up.

I run these quick inventory checks every quarter. To stay on top of inventory and other tell-tale metrics at your favorite companies, add them to your free watchlist, and we'll deliver our latest coverage right to your inbox.

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FRX faces a major patent expiry - one of their drugs goes generics in a month - it is their largest drug. Ahead of that expiry, drug companies normally let inventory levels go very low, because once it goes generic, much of the inventory will be returned to them or will sit in the stores unused because people getting a prescription for this would get the generic automatically. Inventory management is important, but for drug companies, where gross margins are often 90%+, having inventory out there is not tying up so much working capital - it is a problem when drugs go generic though for different reasons though.